This‌ ‌article‌ ‌has‌ ‌been‌ ‌written‌ ‌by‌ ‌‌Sujitha‌ ‌S‌,‌ ‌pursuing‌ ‌law‌ ‌at‌ ‌the‌ ‌School‌ ‌of‌ ‌Excellence‌ ‌in‌ ‌Law,‌ Chennai.‌ ‌This article briefly deals with the various types of debentures classified on a certain basis. Further, this article tries to analyse other related aspects of debentures. 

This article has been published by Sneha Mahawar.

Introduction

Typically, a company can issue shares to raise capital. However, the money generated through the sale of shares is rarely sufficient to cover a company’s long-term financial requirements. As a result, the majority of firms rely on issuing debentures, which are sold either through a private placement or to the general public. Debentures, also referred to as long-term debt, are a method of raising money. Moreover, the issuance of debentures to the public is similar to that of equity shares. Further, there are several types of debentures classified on a specific basis. This article deals with the classification of debentures and other related aspects. 

What are debentures 

The Latin term “debere,” which means to borrow, is the root for the English term “debenture.” A firm can borrow money from the general public by issuing certificates for a specified period of time and at a fixed rate of interest if it needs money for expansion and growth without raising its share capital. This is referred to as a debenture. In simple words, a debenture is a written document that bears the company’s common seal and acknowledges a debt.  It includes a contract for the payment of interest at a given rate due often either half-yearly or annually on fixed dates, as well as for the repayment of principal after a pre-determined period of time, at intervals, or at the company’s discretion.

As per Section 2(30) of the Companies Act, 2013, a “debenture” is any security issued by a company, including bonds, debenture inventory, and other securities, irrespective of it constituting a charge on the assets of the company.

Additionally, it is stipulated that:  

1. the instruments listed in Chapter III-D of the Reserve Bank of India Act, 1934; and 
2. any other instrument that may be authorised by the central government in conjunction with the Reserve Bank of India, issued by a corporation.

Features of debentures

• Commitment: It is a commitment made by a firm that it would pay the holder of the debenture a specific amount of money.
• Face Value: A debenture’s face value often bears a large denomination. It is a multiple of 100 or is 100.
• Repayment: They are issued with a due date that is specified on the debenture certificate. At the time of maturity, the debenture’s principal is paid back.
• Priority in Repayment: Debenture holders have preference over all other claims to the company’s capital when it comes to repayment.
• Assurance of Repayment: A debenture is a long-term obligation. They come with a guarantee of payment by the due date.
• Interest: For debentures, an agreed-upon set rate of interest is paid on a regular basis. The corporation has a set obligation to pay interest. Regardless of whether the firm earns a profit or not, it must be paid by the company.
• Parties to Debentures:
• Company: This is the entity that borrows money.
• Trustees: If a business offers debt securities to more than 500 individuals, a debt trustee must be appointed. A trust deed is an agreement made between the entity and trustees. It includes the company’s duties, debenture holders’ rights, the trustee’s authority, etc. 
• Debentureholders: These are the individuals or organisations that make loans and obtain a “debenture certificate” as proof.
• Authority to issue debentures: The Board of Directors has the authority to issue debentures, as stated in Section 179(3) of the Companies Act (2013).
• Status of debenture holder: His legal status is that of a creditor of the firm. Due to the fact that a debenture is a loan taken out by the corporation, interest is accrued until it is redeemed at a pre-determined rate and interval.
• No Voting Right: In accordance with Section 71(2) of the Companies Act 2013, no firm may issue debentures that include a voting right. Debenture investors are not permitted to cast ballots at the annual general meeting.
• Security: Debentures are often secured by a fixed or floating charge on the company’s assets. The holder of a debenture may dispose off the firm’s chargeable property in order to recoup their investment if the company is unable to pay interest or return capital.
• Issuers: Debentures may well be issued by both public limited companies and private companies.
• Transferability: Using the instrument of transfer, debentures are easily transferable.

On the basis of security of instrument 

Secured or mortgage debentures 

These are the debentures that have a charge placed against the company’s assets as security. They are also called mortgage debentures. Secured debenture holders have the right to demand repayment of their principal as well as any unpaid interest on those debentures from the company’s mortgaged assets. Section 71(3) of the Companies Act, 2013 deals with the issues of secured debentures. There are two categories of secured debentures:

• First mortgage debentures: Debentures with first mortgages provide their holders priority access to the assets pledged.
• Second mortgage debentures: The holders of second mortgage debentures have a second claim on the assets charged.

Unsecured debentures

• Unsecured debentures are debt instruments issued by enterprises that allow investors to contribute money for investments or large-scale expenditures in return for a certificate acknowledging the debt and a written commitment to pay back the principal at a pre-determined time with a pre-determined interest rate.
• Unsecured debentures are by definition those that are not backed by any assets, revenue streams, or holdings of the firm. Holders of unsecured debentures have the same rights as other unsecured creditors of the issuing corporation in the event of default.
• To avoid making the repayment of the debentures subordinate to the repayment of secured loans, corporations typically promise to investors in debentures that they would not secure other loan agreements with their assets prior to the debenture issue.
• As no government buildings or assets ensure bond repayment, government bonds issued under the nation’s seal are equivalent to unsecured debentures.

On the basis of convertibility of instrument

Non-convertible debentures

• Certain debentures provide the option, at the owner’s discretion, to convert debentures into shares after a set period of time. Non-convertible debentures are those debentures that cannot be converted into shares or equity.
• Companies utilise non-convertible debentures as a mechanism to obtain long-term capital through a public offering.
• When compared to convertible debentures, lenders often receive a greater rate of return to make up for the disadvantage of non-convertibility.
• Additionally, they provide the owner with a number of other advantages such as high mobility through the stock market listing, source tax exemptions, and security because they can be issued by businesses with a solid credit rating in accordance with the RBI’s issuing guidelines.
• These must typically be issued in India with a minimum maturity of 90 days. Housing loan firms, gold loan companies, and non-banking financial companies are the main participants in the NCD market. With the systemic fall in interest rates, these companies discovered it to be a useful source of funding.
• Banks, mutual funds, and insurance firms, in addition to ordinary investors, also invest in non-convertible debentures.

Convertible debentures

• According to Section 71(1) of the Companies Act, 2013, convertible debentures are those debentures which have the option of conversion into shares at the time of redemption. Insofar as main collateral is concerned, a convertible debenture is often an unsecured bond or loan.
• They are long-term debt securities that provide bondholders with interest payments. 
• Convertible debentures have the distinction of being convertible into shares at certain intervals. By providing some security, it may help the bondholder mitigate some of the risks associated with investing in unsecured debt. It is a hybrid security that aims to balance debt and equity.
• An investor will receive a fixed rate of return and the chance to profit from a rise in stock price. He can retain the bond until it matures and earns interest even if the issuer’s stock price declines.
• In the case of Deputy Commissioner of Income Tax v. I.T.C. Hotels Ltd. (2003), the Karnataka High Court came to the conclusion that even if the convertible debentures were to be converted into shares at a later time, the expense incurred on such convertible debentures had to be treated as revenue expenditure.
• A convertible debenture is a highly practical financing tool for startups.

Fully convertible debentures

At the expiration of the time period provided, the investors may completely convert these debentures into equity shares. The holders of these debentures eventually become shareholders of the firm after being converted. Additionally, only up to the date of conversion, the interest on these debentures will be paid. Besides, the ability of the firm to compel the conversion into equity shares in accordance with the notice is a key distinction between a fully convertible debenture and other debentures. Even startups with no prior track record might benefit from a fully convertible debenture. 

Features of fully convertible debentures

• The price at which holders change their debentures into shares is known as the conversion price. It is determined by a number of variables, including the book value at the time of conversion, the market price, the anticipated growth in the value of equity shares, etc.
• The number of equity shares that the holder receives in return for a fully convertible debenture is known as the conversion ratio.
• A proportion of the face value is designated as the number of debentures to convert. Additionally, based on pricing, the total money to be converted is converted into the number of equity shares.
• The investor’s right to receive equity shares determines the conversion value of the debentures. They must thus multiply the conversion ratio by the current market rate per equity share in order to arrive at the fully convertible value.
• It begins on the day when the debentures were allocated. The issuer may also exercise the option to convert them into equity shares when the tenure has ended.
• A completely convertible debenture’s coupon payments are determined by the interest rate and creditworthiness of the issuer. The issue’s condition specifies whether the corporation will make coupon payments every six months or every year.

Partially convertible debentures

Debt instruments known as partially convertible debentures allow investors to convert only a portion of their investment into business equity shares at the end of the pre-determined period. At maturity, the investor has the option to redeem the remaining amount of the debenture. Additionally, at the time of issuance, the enterprise chooses the conversion ratio for these debentures. Moreover, the holders of these debentures become shareholders in the corporation to the extent of their holdings after being partially converted into equity.

These are appropriate for businesses with a proven track record. As the conversion results in a smaller equity capital base, they are, thus not particularly well-liked by investors.

Features of partially convertible debentures

• The price at which the real equity share was granted and assigned to the holder is known as the conversion price. The conversion price is determined by a number of variables, including the book value at the time of conversion, the market price, the anticipated growth in the value of equity shares, etc. Therefore, it is important to avoid setting these conversion prices too high or too low.
• The quantity of equity shares the holder acquires in exchange for these debentures is known as the conversion ratio.
• The amount of convertible debentures is expressed as a percentage of face value. Additionally, based on pricing, the partial conversion value is transformed into the number of equity shares.
• The investor’s right to acquire equity shares determines the debentures’ conversion value. As a result, they must multiply the conversion ratio by the present market price per equity share to get the convertible value.
• It fluctuates based on the expiration of the debentures, which typically ranges from one year to five years from the date of allocation.
• The coupon payments are determined by the current interest rate and the creditworthiness of the issuing corporation. The issue’s condition specifies whether the corporation will make coupon payments every six months or every year.
•  The market price of these debentures is influenced by the conversion value and investment value. This product thus combines financing and an opportunity to purchase an equity stake in a company.

On the basis of the ability of redemption

Redeemable debentures

As the necessity of repayment is one of a debenture’s most important characteristics, not all debentures, however, have a set repayment deadline. Debenture issuers generally have the option to pay down such debts at any point before fully winding up. However, this is not the case in terms of redeemable debentures, which have a set repayment deadline. The Issuer is required to pay back such a loan to the original lender or debenture holder by a certain date. Companies can draw in more investors with a redeemable debenture because of this feature. This is so that investors may rest easier knowing they will be paid back. 

The company has the authority to keep the redeemed debentures alive for the sake of re-issues if there is no clause contrary to the Articles of Association or the terms of the issue, or if there is no resolution indicating a willingness to cancel them. The same debentures or alternative debentures may be issued again by the company. The holder of the debentures retains the same rights and privileges after such re-issuance as if the debentures had never been redeemed. In addition, a redeemable debt has many of the same characteristics as a fixed-income product, such as monthly interest payments to investors and the lack of market volatility. The interest they produce is often lower than that of regular debentures, though, a redeemable debenture has a pre-determined payment date. Such a system does not mimic market instability.

Features of redeemable debentures

• Repayment: Repayment is the main characteristic that sets this loan instrument apart. The method of repayment, however, might differ. An issuer has the option to redeem all of its debentures in a single go. Alternatively, a business may decide to make monthly payments or instalments over the course of the loan.
• Redemption value: Another crucial aspect of a redeemable debt is the amount at which it Is redeemed. A Company or issuer can redeem at par its lot of such debentures. On the other hand, it can also choose to redeem at a premium. That means paying a price that is higher than the face value of such debentures. 

Irredeemable debentures

One form of debenture that is categorised based on the ability of redemption is the irredeemable debenture. Such debentures cannot be redeemed while the issuing firm is still in existence. To put it another way, irredeemable debentures may only be redeemed once the issuing firm dissolves. Section 120 of the Companies Act, 1956 dealt with irredeemable debentures. However, there is no such provision in correspondence with the Companies Act, 2013.

They can also be redeemed when they run out or if the firm issuing them is prepared to pay back the borrowed money. However, such a thing does happen pretty seldom. These bonds are also known as perpetual debentures or perpetual bonds since the corporation issuing them does not have a plan for repaying the money borrowed. Additionally, they don’t have a pre-determined redemption date at the time of issuance. It should be mentioned that the issuing enterprises are obligated to pay the pre-determined interest on the debt instruments. 

It is seen as a financially advantageous method of borrowing. Moreover, the call option is available to issuers, and the timing for it is specified every five years after issuance. These debentures are often issued by major manufacturing entities or financial institutions.

Features of irredeemable debentures

• Perpetual bonds do not have a maturity date, as was previously said. However, the right to issue callable debentures is reserved for issuers.
• On these bonds, investors are entitled to interest. Notably, the payout is based on how profitable the issuing firm was in the previous year.
• High liquidity risk and low to moderate credit risk are associated with irredeemable debentures. The debt instrument is further exposed to a moderate interest rate risk.
• Rs. 10 lakh is the minimum investment value for this debt product. It should be emphasised that high net-worth investors (HNI) or retail investors can get irredeemable debentures in the resale market, with the maximum investment value being Rs.560 lakh or higher. Additionally, the price is largely influenced by the interest rate that will be charged, both now and in the future.

On the basis of registration

Registered debentures

These debentures are listed in the debenture-holders register of the entity with each holder’s complete information. Any securities of the Company that are issued and exchanged for the debentures in accordance with the Registration Rights Agreement and contain terms identical to the debentures are referred to as registered debentures. However, these securities will be registered under the Securities Contracts (Regulation) Act (1956) and  will not contain terms relating to transfer restrictions. In simple words, these debentures are such in which all information, including addresses, names, and holding details of the debenture holder, is recorded in a register maintained by the company as per Section 88 of the Companies Act, 2013.

These bonds are payable to registered holders, or those whose names are included in the register. Debentures that are registered are not negotiable. These bonds cannot be transferred by simple delivery. Similar to shares, these debentures are transferable in accordance with Section 56 of the Companies Act, 2013. These cannot be transferred to someone else unless the company’s board approves the standard instrument of transfer. 

The registry of debenture holders contains the names of these holders as well as information about the quantity, face value, and kind of debentures they currently possess. The register is filled out with the buyer’s name. Only the people whose names the debentures are recorded receive the interest coupons.

Bearer debentures

Debentures that may be transferred by simple delivery and are paid to the bearer of the instrument are known as bearer debentures. The registry of debenture holders does not keep track of bearer debentures, and registration of transfer is not required. These debentures are transferable, like negotiable instruments by means of simple delivery. In the case of Calcutta Safe Deposit Co. Ltd. v. Ranjit Mathuradas Sampat (1970), the Calcutta High Court observed that the debenture holder is entitled to recover the principal and interest in case of due. When it is not paid, he or she can seek winding up and if the suit is otherwise competent, the company cannot ask him to explain how he came by the debenture or why he did not collect the interest for a long time. Further, the Court highlighted that Section 118 of the Negotiable Instruments Act (1881) applies and therefore, every holder of a bearer debenture is presumed to be a holder in due course unless the contrary is proved.

Features of Bearer debentures

• Bearer debentures are printed on paper and issued in physical form.
• The Bearer debenture holder must present the interest payment coupons that are physically linked to the security to the bank or the issuing corporation in order to collect interest payments.
• Bearer debentures may be redeemed within 30 days of the maturity date.
• When selling bearer debentures, there is no need for a third party or middleman, making the process relatively simpler. As a result, it may be easily transferred by just giving the other person the certificate.

On the basis of coupon rate

Specific coupon rate debentures

• Debentures are categorised as specified coupon rate debentures when the interest rate is pre-determined at a certain rate, or the coupon rate, which may be fixed or floating. 
• In most cases, the bank rate and the floating interest rate are related.

Zero-coupon rate debentures

• There is no set interest rate on these debentures. Such debentures are issued at a significant discount in order to recompense the investors, and the difference between the issue price and the nominal value is regarded as the amount of interest associated with the length of the debentures.
• Debentures with a zero-coupon rate have no coupon rate, or we may argue that there is no coupon rate at all. In these kinds of debentures, the holder will not get any interest. The discrepancy between the issue price and the debenture’s face value is the implicit interest or advantage. These debentures must be redeemed for their full face value. These are also known as “Deep discount bonds.”
• For instance, a debenture having a face value of Rs. 100, is issued at a 50% discount. In this scenario, the investor simply has to spend Rs. 50 to subscribe to the debenture. She does, however, receive Rs. 100 back when the loan matures.

Overview of the classification of debentures

Basis	Classification
On the basis of security of instrument	Secured or mortgage debentures and unsecured debentures
On the basis of convertibility of instrument	Non-convertible debenturesConvertible debenturesFully convertible debenturesPartly convertible debentures
On the basis of the ability of redemption	Redeemable debentures and Irredeemable debentures
On the basis of registration of debentures	Registered debentures and unregistered / bearer debentures
On the basis of coupon rate	Specific coupon rate debentures and zero coupon rate debentures

Advantages of issuing debentures

• It has become more typical for company directors to lend their own company and secure debentures that will eventually protect them from current and future market insecurities as most banks are becoming less willing to offer business loans (especially to startup firms) combined with the heavy obligations they face.
• Debentures mature over time and assist in securing long-term capital for the establishment and expansion of enterprises.
• Debentures, as opposed to other debt instruments, have a fixed/definite maturity period and a fixed (unchanging) rate of interest throughout their term. As a result, investors receive a fixed amount as specified at the time the debenture was issued, which over time can be a reliable source of income to support oneself financially.

Disadvantages of issuing debentures

• Debentures have the significant drawback of having no influence over ownership, notwithstanding the possibility that equity shareholders may be required to periodically exert control over its operations by issuing debentures and/or compelling conversions). Holders of debt obligations do not have voting rights to safeguard their interests in the event of market instability, unlike holders of other fiscal instruments.
• Another drawback is that investors must pay taxes on debenture interest rates in accordance with government regulations, whereas owners are exempt.

Conclusion

To sum up, a debenture is just an acknowledgement of a debt. It is a kind of  loan capital raised from the general public by the firm. In the realm of finance, a debenture is a note of promise for a long-term corporate bond that is often secured by the goodwill and moral character of the borrower as well as certain assets. Typically, a company or firm is the borrower, while the general public is the lender. Based on different factors including security, duration, convertibility, etc., there are many types of debentures. Accordingly, there are many different forms of debentures, including registered and bearer debentures, secured and unsecured debentures, redeemable and irredeemable debentures, convertible and non-convertible debentures, and debentures with zero coupon rate and specific rate. Debentures stand apart from other types of debt in part because they lack collateral backing, meaning that no money or asset of any kind is guaranteed to support the obligation. Debenture issuing companies have an opportunity to succeed with a safe source of long-term capital. Due to its limited liquidity and lack of collateral or other means of securing ownership, crowdfunding has several drawbacks, particularly for businesses that struggle to win over the trust of investors.

FAQs

How does a debenture differ from a bond?

One form of a bond is a debenture. It specifically refers to bonds with longer maturities and is an unsecured or non-collateralized debt issued by a company or other entity.

What’s the risk factor involved while redeeming debentures?

If the debentures are removed and sent, there is a risk of losing the interest payment coupons. Therefore, the bond must be physically presented to a bank for redemption at the time of maturity.

What’s the significant risk associated with unregistered debentures?

The main threat in buying bearer debentures is that they may be readily utilised for tax evasion and money laundering. The rationale is that bearer debenture holders are unable to realise any income from owning this kind of debenture.

What is the major difference between registered and bearer debentures?

Since they can be transferred by simple delivery, bearer debentures are known as unregistered debentures. On the other hand, Registered Debentures cannot be transferred by simple delivery, and all necessary information is recorded in the debenture holders’ Register.

How do partially convertible debentures differ from fully convertible debentures?

Partially Convertible Debentures, also known as PCDs, are different from Fully Convertible Debentures in that the investor can retain a portion of the debenture value in cash as security value. At the same time, the remaining debt is converted to equity.

References

• 401KarishmaKhurana1.pdf (du.ac.in)
• CompanyLaw_BOOK.pdf (icsi.edu)
• Chapter-2 .pmd (ncert.nic.in)
• https://nios.ac.in/media/documents/srsec320newE/320EL26.pdf
• Debenture Definition (investopedia.com)

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